A new blow for annuities

The potential implications are substantial. Business advisory firm Deloitte believes that a pensioner with a £100,000 fund could lose between £300 and £1,100 a year as a result of the regulatory changes. This is because insurance companies will be forced to change the way they assess risk and future liabilities.

At the moment, insurers use government bonds and corporate bonds to ensure annuities return a guaranteed income for the rest of the annuitant's life, but the matching adjustment currently being debated could see insurers obliged to use 'risk-free' government bond rates to calculate future liabilities or put aside more reserves to guard against default.

The point here is that government bond yields are substantially below corporate bond yields, which means that insurers face a choice between either cutting annuity rates or putting aside much higher levels of reserve capital. Annuity providers must hold reserves for expected defaults of corporate bonds and these come from the extra expected yield from holding corporate bonds rather than government gilt stocks. This extra yield is known as the credit spread and, under the new rules, any underlying investment that is deemed to be less than 100 per cent risk-free (that means anything apart from a government bond) must be reserved against in full, that is 100 per cent of the credit spread. In fact, the only good news is that the new rules do not apply to existing annuities. But as the rules will apply across all of the eurozone, there are other problems, too. Spanish insurance companies, for example, will be able to buy Spanish government bonds yielding 6 per cent knowing that as sovereign debt they will be classed as risk-free. There are suggestions that some form of risk assessment is being considered for sovereign debt - but that would be a veritable nightmare.

And it gets worse, because annuity rates calculated by gender will be outlawed from 21 December this year. Under the current system, men are offered higher annuity rates than women because statistically men don't live as long as women. Under proposed legislation, this differentiation will not be allowed. This leaves insurers with another unpalatable choice. Increasing women's rates to the same as men would cost too much, so it looks as though the two will meet half-way, women gaining an increase and men facing a further cut.

For the insurers themselves there are three main headache-inducing areas: compliance, the timetable for implementation and the ongoing battle to iron out or do away with some of the less workable aspects of proposed legislation. The next directive is due to be voted on in September, and this will set the date for the start date of Solvency II legislation. Implementation has not yet been postponed and comes in on 1 January 2014. And this is causing a number of problems because insurance companies are expected to change their systems to meet stringent new capital requirements and risk management assessment even though some of those requirements are still being thrashed out.

Insurers have had to start looking at adjusting the product mix, de-risking and, of course, increasing prices. Part of this shift reflects a growing awareness that having a more sophisticated internal risk assessment regime will actually be a good move. The only trouble is that it will almost certainly be much more expensive to implement. However, insurance companies have been hit over the years by pension mis-selling, poor investment products and full-blown scandals such as with Equitable Life. So any move to avoid a repeat of any of these has to be welcomed. It could also be argued that life assurers should have even more sophisticated risk models, given the much greater than expected increase in longevity rates, and the recently unstable nature of more traditional investments such as bonds and equities. And it goes without saying that improved business decisions could ultimately lead to lower capital requirements, but the costs involved will mean that annuity rates will suffer.

Solvency requirements will be much more comprehensive than in the past, with both insurance risks and asset-side risks being taken into account. In fact, areas currently not covered will include: market risk, or more specifically the value of the insurer's investments; credit risk (exposure to bad debt); and operational risk, which covers system breakdowns or malpractice.

So what are the choices for anyone approaching retirement age? Professional advice is certainly a must. And doing the right thing now is so much more important than it was in say 1981, when a 65-year-old male could buy an annuity for life paying 16 per cent a year. Not so good then, when inflation was over 20 per cent, but rather nice when inflation subsequently fell to single figures. But by purchasing a fixed-rate annuity now, you have to remember that inflation at less than 3 per cent has more upside potential than downside. Higher inflation acts like a cancer on annuity income, unless it is index-linked. And there are sacrifices here, too, because index-linked annuities can initially pay out as little as half a fixed rate annuity, and decades for indexation to close the difference.

For those with a larger pension pot, there is the option of income drawdown, but this is more expensive to administer and involves a certain amount of risk as the principal pension pot remains invested. Whichever way you go, it seems that annuities have lost their appeal and will offer a poorer income stream.

How annuity rates are falling